The Spike in Interest Rates

I’m back from a couple of weeks on the road, and was greeted on my return by the precipitous rise in the interest rate on long-term U.S. bonds—in less than a week, the yield on the ten-year note jumped more than fifty basis points (in layman’s terms, it rose more than half a percentage point), which is a huge move for an asset as theoretically stable as a U.S. government bond. This now has pundits and bloggers fretting about inflation, and about the prospect that higher interest rates will squelch the nascent recovery before it can even get started. (Although, to be honest, most of the people predicting disaster as a result of higher interest rates don’t think there was ever a hope of recovery to begin with.)

The size of the move was undoubtedly eye-catching, but the notion that investors are starting to panic about inflation seems improbable at best, given the fact that even at its peak this week the ten-year note was yielding only around 3.7 per cent, which is still cheap by historical standards. (If you really thought there was a meaningful prospect of skyrocketing inflation, would you lend money to the government for ten years at only 3.7 per cent?) And while there is reason for concern about the recent rise in oil prices, given their psychological (and material) impact on consumer spending, the evidence of inflation in the real economy is just about nonexistent.

At the same time, the argument that a 3.7-per-cent—or four-per-cent—long-term interest rate is going to demolish the would-be recovery is mystifying. Generally speaking, steeper yield curves—that is, when long-term debt has a significantly higher interest rate than short-term debt—are what you’d expect when an economy is getting stronger (or at least getting less weak). And surely part of the weakening demand for long-term government debt reflects the greater (if still fragile) willingness of investors to take on some risk. The minuscule yields we saw on the ten-year note (which earlier this year fell as low as 2.5 per cent) were the result of, more than anything else, the enormous fear and risk aversion that gripped investors. The waning of that is, on balance, a good sign. While it’s true that meaningfully high interest rates would put a significant crimp in corporate and individual borrowing and the like, 3.7 per cent doesn’t count as meaningfully high (and, in fact, the ten-year yield has dropped quite a bit in the past two days alone). And while a 5.4-per-cent mortgage rate will slow down refinancing and, to a lesser extent, new-home buying, that was never going to be the engine of recovery for the U.S. this time around. There are plenty of things to worry about at the moment, but inflation and interest rates probably shouldn’t be high on that list.

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